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Finance and Wealth Part One

*Note: This is taken from a verbal presentation in my Economic Sociology class over a chapter of Miguel Centeno and Joseph Cohen’s book “Global Capitalism” on finance and wealth. I’ll post part two later. Only slight edits…

Socialization of Risk

Financial risk is not inherently bad. Indeed, the existence of structured financial risk is often touted as a fundamental aspect of capitalism’s positive effects. This is where we see the term “creative destruction” come into play, or where the market rids itself of unworkable or inefficient enterprises and promotes beneficial and positive aspects of the economy. The authors argue, however, that the pursuit of extreme market liberalization can result in extreme systemic economic risk.

Investor mania and market bubbles existed long before the advent of liberalization, but the markets under mid-century economic systems had many buffers between capital and the sorts of excessive financial risk we see today. By the late 20th century these buffers were thought to be overly burdensome, and deregulation in the 1980s and 1990s resulted in increased economic growth and innovation. As a result of the reduced oversight of centralized government management, control devolved to a small group of private financial intermediaries whose incentive environment directed their investment decisions towards increasingly short-sighted monetary gains that eventually constituted a threat to economic stability.

Perhaps the most salient feature of this increased threat to stability, the authors argue, is the problem of financial leverage. “Leverage allows investors to make bets with much more money than they actually have.” This necessarily denotes the possibility of multiplying returns on investments, but also allows for much greater losses. As with risk, there is nothing bad about financial leverage in an of itself. However, the lifting of capital requirements (having a certain amount of equity in an investment) in the 1990s represented an unsustainable chasm between incentives for prudent long term investment and short-term, casino-style, gambling with other peoples’ money. The authors note that the “global financial system collectively gambled that growth would be eternal, so that tomorrow’s earning would always be more than yesterday’s debts.” Essentially we all borrowed from each other in increasing amounts based on a future growth that was unsustainable, simultaneously guaranteeing an inevitable economic collapse and insuring that we’d all pay for it.

The other salient feature of our current market structure is that such investment decisions are increasingly made by a smaller number of large economic actors. Which is to say, these actors are “too big to fail,” and have resulted in the public effectively subsidizing their risky investments. This leads to what we call “moral hazard,” where these large investors are more comfortable assuming risky endeavors because they will very likely not have to pay for their potential failure. Indeed, this is what essentially happened in 2008 with the mortgage meltdown – there was no institutional disincentive to allocate so much capital into a well-recognized housing bubble. The short-term gains were too great, and the existence of collateralized debt obligations and their synthetic counterparts presented a false sense of security.

This is when the authors ask if the very architecture of our current system promotes too much risk. The house of cards that the aforementioned financial intermediaries created – built with opaque financial instruments amongst a leverage intensive and complex market – were quite fragile and prone to debilitative circumstances, like a widespread drop in housing prices. Because of the small number of actors and interlocking aspects of a global financial system it could lead, and did lead, to “what one practitioner called a cascade of failure.” The authors doubt if any regulatory scheme would have been able to prevent what happened.